As we look forward to better economic growth, investors are regaining their risk appetite. Consequently, small- and micro-capitalization stocks and exchange traded funds are gaining momentum.

Small and microcap stocks, which have market capitalizations of about $50 million to $300 million, are the most volatile market segment and generate a larger portion of their revenues from within the U.S., writes Max Isaacman for Minyanville.

Additionally, small-cap companies are largely in the crosshairs of potential corporate buyouts, which will likely increase as the economy improves.

Typically, during the initial stages of a bull market rally, the more nimble small capitalization stocks are able to quickly ride the wave upward.

However, on the downside, small-cap companies tend to get hit the hardest during financially tight periods, such as the 2008 financial crisis when it was particularly difficult to access free capital.

Micro-cap ETFs have been outperforming the S&P 500. For instance, the Guggenheim Wilshire Micro-Cap ETF (NYSEArca: WMCR) gained 10.2% over the past three months and the PowerShares Zacks Micro Cap Portfolio (NYSEArca: PZI) is 11.7% higher, compared to the 6.5% rise in the S&P 500 over the same period.

WMCR holds about 800 components and no single company makes up more than 1.1% of the overall assets. Financial sector stocks make up 26% of the fund, followed by 23% in health care, and 18% in technology.

PZI follows the Zacks Micro Cap Index, which identifies micro-cap stocks with the highest potential to outperform passive benchmark of micro-cap indices and other micro-cap strategies.

While ETFs allow investors diversify across the micro-cap space, the underlying micro-cap market faces some liquidity concerns.

“The ETF’s portfolio churn means it loses lots of money to market-impact costs and bid-ask spreads,” Morningstar analyst Samuel Lee warned of PZI.

Some small-cap ETFs include:

  • iShares Russell 2000 (NYSEArca: IWM)
  • iShares Core S&P Small-Cap ETF(NYSEArca: IJR)
  • Vanguard Small Cap ETF (NYSEArca: VB)

For more information on small capitalization funds, visit our small-cap category.

Max Chen contributed to this article.

Full disclosure: Tom Lydon’s clients own IWM.

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